Determinants of Asset Backed Security Prices in Crisis Periods

William Perraudin & Shi Wu

Comments by:

Stephen SchaeferLondon Business School

Conference on:

Liquidity: Pricing and Risk ManagementBank of England, June 23-24, 2008

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Models of Credit Pricing

• Credit pricing models currently unsuccessful in explaining level of spreads (structural models)

­ intensity models simply calibrate to market spreads

• Wide dispersion in prices / spreads even within rating:

­ relative to dispersion explained by models

­ but … data quality often poor

• This paper asks:

­ what explains deviations of spreads / prices from the rating category average?

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What does the paper do?

• Large sample of prices on Home Equity Loan (HEL) and Manufactured Housing Loan (MHL) ABS

• Fits average credit spread curves by credit rating category

• Attempts to explain deviations from average pricing

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Dispersion in Credit Pricing

• Studies of corporate debt (e.g., Collin-Dufresne, Goldstein & Martin, 2001) have also found high level of unexplained variation in prices

• Understanding the nature and source of this variation is an interesting and important question

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Methodology

• Uses transition matrix approach to fit time-homogeneous, rating-specific credit spread term structures to large sample of prices HEL and MHL

• Asks whether deviations from average pricing by credit category can be explained in terms of proxies for:

­ risk premia

­ liquidity

­ deviation between market and rating agency assessment of collateral quality (“disagreement”)

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1. Rating Transition Model

• Approach (as in Jarrow, Lando & Turnbull, 1997) employs risk-neutral transition matrix

• Presented as “interpolation technique” however model makes behavioural assumptions:

­ based on no-arbitrage condition

­ … but this implies pricing errors that are zero or, realistically, small while in crisis period they are substantial

• Minimising squared price errors sacrifices fit in spread at short maturities for fit at long maturities

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2. Default Risk for Given Rating May Change over Time

Source: Moody’s KMV – “Credit Risk matters”, Fall 2007

Equal estimated default probability for “A” in 2001 and “B” in 2007 . .

• Assumption of time-homogeneous transition matrix but evidence that default probability for given credit rating category declined substantially after 2001 recession

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3. Modelling Prices Using of Spreads

• Spreads (e.g., to Treasury curve) useful descriptive tool but may be difficult to use in pricing models because:

­ interest rate risk and credit risk are fundamentally linked (negative correlation between credit spreads and Treasury rates – “low duration” puzzle)

­ convenience yield in Treasury rates – particularly in crisis periods – means not clear which rate should be used as proxy for riskless

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US$ 5-Year Swap Spread

0

20

40

60

80

100

120

4. What is the appropriate riskless benchmark for measuring spreads?

• Paper uses Treasury rate but potential problem of (time-varying) convenience yield on Treasuries

“Decomposing Swap Spreads”, Feldhütter & Lando (J. Fin. Economics, forthcoming)

August 2006 – December 2007

June 07

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Results – what explains the residuals?

• Risk premia

­ limited significance of Fama-French SMB & HML factors

­ perhaps noisy beta estimates; 30 day moving window regression estimates

• “Disagreement” between market and rating agency

­ sub-rating category dummies significant

­ suggests sub-ratings are significant but not clear why “disagreement”

• Liquidity

­ appears that issue size is significant

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Noise in Returns on Individual Corporate Bonds and on Portfolios

• For individual bonds, Collin-Dufresne et. al. (2001) find that return on individual firm equity explains relatively little of changes in corporate credit spreads..

• But, at a portfolio level, for BBB and below, equity is much more significant – implies that much of the unexplained variation at the individual asset level was diversifiable or, noise.

Hedged Against All AAA AA A BBB BB B

10-year Treasury bond 54 34 40 50 57 78 9910-year Treasury + Firm Equity 49 34 37 45 52 66 65

10-year Treasury bond 50 19 23 33 47 93 9510-year Treasury + Firm Equity 28 18 19 26 28 27 48

Individual Bonds

Equally Weighted Portfolio

Residual Variance as Percentage of Unhedged Variance

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Summary – Pricing in the Crisis

• Currently difficult to understand either level or cross-sectional variability in credit spreads in crisis.

• High level of some spreads is particularly difficult to understand

­ may be less to do with detailed characteristics of instrument

­ .. and more to do with fact that many of the holders (e.g., hedge funds) were leveraged and their need to undertake forced sales as a result of falls in collateral values.